Most exchange traded funds (ETFs) are put to the test via backtesting. But what, exactly, does that mean?
Thaddeus Malley for ETF Guide says the average investor should be aware of this.
Backtests, he says, share common statistical metrics: standard deviation, Sharpe ratio, beta, alpha, R-squared and maximum up/down draw. All of these formulas all work together to explain how the hypothetical index performs and how much risk is associated with it.
And now, for your vocabulary lesson:
- Standard Deviation: shows how much the index fluctuates above or below its average.
- Sharpe Ratio: a ratio that shows the return dividend by the standard deviation by the index. A ratio above 1 is desired.
- Beta: The correlation of an index to a benchmark.The higher the beta, the closer the index moves with most markets.
- Alpha: The amount of return the index has done is excess of the benchmark.
- R-squared: The predictability of an index to move with the benchmark.
- Maximum Up/Down Draw: Explains the positive or negative trends within an index, and the benchmark it belongs to. Gives insight into the losses you may entail while holding the particular ETF.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.